“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
—Warren Buffett, Fortune, 1999
The black swan that killed the longest bull market in history arrived in the form of a bug, and it descended with such ferocity that the Dow Jones industrial average had its worst quarter since 1987, more than a generation ago. That crash was caused by technical factors and was largely a one-day event; this crash comes thanks to a global stoppage of much of humankind’s economic activity. For precedent and parallels, we might look to 2000–2002, when we were hit by the double whammy of the dotcom crash and 9/11, and to the financial crisis of 2008–09. But it’s rather futile to search for analogs to the coronavirus crisis. Like any crisis, this one was unexpected, unplanned for, and largely unprecedented. That’s why we call it a crisis.
For investors, the operative question is simple, albeit very broad: In the midst of this crisis, what do we do?
To help you try to answer that, let me ask two slightly more specific questions.
- What publicly traded companies can make it “to the other side” of the coronavirus? In other words, which companies’ business models won’t be completely destroyed by the bug-swan? Investors pondering this question should keep a company’s balance sheet in mind: Too much debt will drag a company down during hard times as surely as a swift current drags a weak mule downriver.
- What companies will not only survive but also prosper in a post-coronavirus world? These are the businesses I’m currently targeting, and these are the ones I think you should be too.
The above questions are better ones to ask than the current ones being bandied about. “How long is the pandemic going to last?” and “When will the economy recover?” would be good questions if the answers were knowable. But the truth is, nobody knows! In this way it’s no different from past crises like 9/11 and the 2008–09 meltdown. With the benefit of hindsight, it’s obvious that those crises were transient. But as anyone who lived through them, including me, can tell you, they felt anything but. Day by day the bear market ground slowly on—until it didn’t.
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Here’s a good rule of thumb: If a business you are considering for investment depends upon a speedy return to normal, you should look elsewhere. Warren Buffett has often said that you should invest in businesses that you wouldn’t mind owning if the stock market were closed for an extended period. While I don’t think it will come to that, it’s a useful mental construct. Implicit in this are the going-concern questions mentioned earlier: Is the business model durable? And are its debt obligations manageable?
In a crisis like this, first-principle questions like these should be at the forefront of every investor’s mind. Yet it’s always amazing how, in times of crisis, people so quickly and utterly forget them. People panic, and they run around like chickens—or swans—with their heads cut off.
The trap of Chicken Little thinking
In this frenzied environment, one cardinal rule of investing is especially pertinent: By definition, the value of a business today is simply the sum of its future profits discounted back to the present at an appropriate interest rate. Forget the technical, mathematical part of discounting back the profits—if you’re interested, you can read more about it in Buffett’s 1992 annual letter. The point is that a business’s value today is made up of a long string of profits extending out into the future. As anyone who’s ever done a discounted cash-flow analysis can tell you, the vast majority of a business’s present value—roughly 70% for many businesses—comes not from this year’s earnings, or next year’s, but from the earnings that should accrue over the decades.
This principle is as unerring as the law of gravity—yet everyone forgets such laws in Chicken Little times like the one that prevails today. Investors dump securities that have long, deep, and growing profit streams because “this quarter’s going to be awful” or “it’s going to take a while for them to get back to a post-corona normal.” At the same time, they embrace businesses that are currently doing well but whose long-term future is bleak.
It’s madness, and it will end poorly for those who engage in it. For example, the pandemic has been a bonanza for Kroger, the nation’s largest stand-alone grocer, whose same-store sales grew 30% in March. In normal times, Kroger is lucky to grow same-store sales 2% to 3%. Longer term, Kroger is fighting for its life against traditional brick-and-mortar retailers like Walmart, Costco, and Target. Then there’s also the matter of a small company out of Seattle named for a big river and run by a dread pirate named Jeff Bezos. However, because crises foreshorten the time horizon of most investors, Kroger’s shares are up more than 10% year to date, beating the market by roughly 25 percentage points. Its price/earnings ratio, according to FactSet, is both trending higher and above its five-year average.
Normally when a company’s P/E multiple expands, it’s because the market begins to understand that the business is getting better. Its growth prospects are accelerating, or its competitive edge is growing. Neither of these things is true with Kroger. On the contrary, Walmart, Costco, and other traditional retailers will continue to pressure Kroger with lower prices once this crisis has passed, and Amazon will continue to unleash its double-barreled can of whoop-ass—lower prices and greater convenience.
There are dozens of other mediocre companies currently experiencing the same kind of short-term, transient tailwind—Kimberly-Clark (paper towels and toilet paper), Hormel, (canned food) and even Nautilus (home gyms). I put pharmaceutical companies into this category: Sure, one of them will probably hit the jackpot with a coronavirus treatment, but it won’t change the industry’s fundamental business model. Pharmaceutical companies spend billions of dollars trying to develop a new drug, and if they’re lucky one hits, and they get a 20-year exclusive right to earn a return on their investment by selling at monopoly prices. When this period ends, however, they’d better have other drugs in the pipeline to replace that profit stream. In this way they are no different than oil and gas companies, which every year must replace the reserves they’ve pulled out of the ground. And not for nothing: Pharma’s business model of monopoly pricing may make economic sense but is deeply unpopular with Americans and may be upended.
Companies like Zoom (video conferencing) are more difficult to judge. They are doing well in these market conditions, but they also may have long-term tailwinds. I haven’t researched Zoom in any depth, but I will point out that most companies in a free-enterprise system don’t have a long-term competitive edge that allows them to earn high returns for an extended period. Most fail the test that Buffett sets out in the quote atop this column. What usually happens is that someone comes up with a good idea and brings it to market, where for a time it enjoys great success. Then others copy it, improve upon it, and/or sell it for a cheaper price—and the innovator’s once-healthy returns dwindle to merely acceptable ones. Already, Zoom has been exposed for important gaps in its privacy and security measures, and there’s no doubt that competitors are focusing on that gap right now. (Read more about Zoom in this recent Fortune feature.)
Rare advantages
Companies that do pass Buffett’s test and possess a durable competitive advantage are rare, but they do exist. Because they are rare, they should be both sought out and treasured. One of these is Alphabet, which I own for my clients and have written about before favorably for Fortune.
Alphabet has nine platforms with more than 1 billion users, most of which enjoy mail, maps, Chrome, Android, and so on for free. Alphabet’s main subsidiary, Google, dominates its industry to such an extent that “Google it” has become synonymous with Internet search. If your business has any online presence—which means 100% of businesses—you must advertise on Google, giving the company a large, stable and growing cash-flow stream. Many have tried to compete with and co-opt this profit stream; all have failed, leading even Bezos to say, “Treat Google like a mountain. You can climb the mountain, but you can’t move it.”
Alphabet meets other first-principle tests. Net of debt, Alphabet has $115 billion of cash as of its last quarterly filing—it’s unquestionably going to get to the other side of this crisis. Moreover, many of the long-term trends favoring its businesses will not only continue, they will accelerate. Digital advertising is now roughly half of all U.S. advertising, but if you count other marketing services like in-store displays and direct mail, then digital’s share is only 25%. The extended distancing of consumers from retail has further accustomed people to search and purchase goods and services online, so digital’s share is likely to continue to climb. Likewise, shelter in place has made us even more addicted, if such a thing were possible, to our mobile phones. This is bullish for its Android segment. Finally, Alphabet’s cloud-computing division, which was already picking up steam under new leader Thomas Kurian, will benefit from a massive surge in working and learning from home.
Alphabet’s net present value—the value of all its future profits, discounted back at an appropriate rate—is therefore large, and its stock price should grow over time along with its prospects. But investors’ panic-induced, foreshortened time horizon has caused Alphabet’s stock to decline year to date—less than the market’s decline, but not by much. The logic (or at least the line of thinking—it’s not logical) goes like this: Advertising will surely be down in 2020. Advertising is the company’s largest segment. Therefore earnings will be poor. Therefore, sell.
Given Alphabet’s long-term prospects, it is lunacy to sell based on a one- or two-year slowing of the company’s many long-term secular growth trends. Removing one or two years of a company’s near-term earnings stream does almost nothing to a net-present value calculation. A business’s present value is in the certainty that the company will be bigger, better, and more prosperous in the years to come. Alphabet certainly passes this test—and under new and hungry CEO Sundar Pichai, the company is beginning to possess a swagger, a discipline, and a bottom-line focus that might make Bezos smile.
Just as there are dozens of Kroger-like companies enjoying short-term tailwinds that will soon pass, there are dozens of Alphabet- and Amazon-like companies with long-term tailwinds that will emerge better and stronger on the pandemic’s other side. Crises like these present great opportunities to buy them. You just have to ask the right questions to find them.
Adam Seessel is a portfolio manager at Gravity Capital Management LLC, a registered investment adviser. Certain of the securities mentioned in the article may be currently held, have been held, or may be held in the future in a portfolio managed by Gravity. The article represents the views and belief of the author and does not purport to be complete. The information in this article is as of the publication date, and the data and facts presented in the article may change.
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